By Simon Shuster
Staff Writer
Anatoly Chubais' long-held dream of free-market electricity reform looks to be in disarray after two giant business groups, Gazprom and Interros, emerged as the favorites to carve up the country's power production and form regional monopolies.
Gazprom announced Thursday that it would pool its electricity assets with the country's biggest coal supplier, the Siberian Coal and Energy Company, known as SUEK. The merger will create a holding company worth about $12 billion, by far the largest in the country's power sector, with Gazprom in majority control.
Considering the holding's wealth, its closeness to the state and its near monopoly over the fossil fuels used to produce electricity, analysts said it could easily dominate power generation, creating just the kind of monolith the reforms had sought to break apart.
Chubais, head of Unified Energy Systems and the architect of the reforms, was unable to conceal his frustration Friday when asked about Gazprom's move into coal.
The joint venture is "a major mistake for the government, and sadly not its first mistake," Chubais said during an hourlong conference call. Asked to clarify, he added, "I think you heard me right."
Earlier this month, Interros holding company announced that its president, Vladimir Potanin, would buy out longtime business partner Mikhail Prokhorov, the CEO of mining giant Norilsk Nickel. The sale of Prokhorov's Norilsk shares alone is expected to leave him with about $7.5 billion in cash. Prokhorov said he intended to go into the electricity business.
Assuming he does, Prokhorov's cash could buy him nearly 20 percent of all the generation assets being spun off from UES, said Dmitry Terekhov, an analyst with Antanta Capital.
Although the Gazprom-SUEK venture is far wealthier, its wealth is in the form of UES shares, which are worth pro rata stakes in generating assets, but are not as maneuverable as Prokhorov's cash.
In light of this, the two holdings would have "comparable muscle" in the power sector, said Tigran Hovhannisyan, a utilities analyst at MDM Bank.
Both are likely to use it in laying claim to strategically placed generating companies. Yet their management styles will be different, Hovhannisyan said.
"Prokhorov is a businessman. He wants to consolidate [electricity] stock and build a business that will bring him profits," he said. "Gazprom is more interested in building an empire. ... It has a mania for buying these electricity assets."
Prokhorov is likely to take control of power stations in the north of Russia, where Norilsk and gold firm Polyus, the two companies he helped to found, run some of the country's biggest mining operations. The Gazprom-led venture is expected to buy out generators in the south, where SUEK mines its coal, and in the regions where Gazprom extracts natural gas and oil, including Murmansk, Omsk and the Yamal Peninsula.
Mosenergo, the country's largest generating company and the sole provider of power to the capital, is already controlled by Gazprom.

Gazprom Bids for Control
Gazprom has made no secret of its plans for the electricity sector. It wants nothing short of dominance.
In a recent speech, Gazprom CEO Alexei Miller claimed electricity as part of his company's "core business." And the strategy statement on its web site says, "There is an understanding that today Gazprom is the most interested of all in developing Russia's power sector."
Unlike Surgutneftegaz, which analysts consider more of a niche oil producer, Gazprom has set itself the goal of becoming "a global energy firm with full vertical integration," the statement said. That means it wants to control production, transport and sales, at home and abroad, and it wants to do so with gas, oil and electricity.
The joint venture with SUEK is a major advance.
Currently, coal makes up about 15 percent of the fuel used at power stations, but President Vladimir Putin said last week that this figure must rise to 35 percent, roughly the European average, by 2015.
Such an increase would be much to Gazprom's advantage. Natural gas now accounts for about 60 percent of the power sector's fuel balance, and shifting that toward coal would free up gas for Gazprom to sell abroad, where it is sold for roughly five times the domestic price.
SUEK churns out 30 percent of the nation's coal and holds significant stakes in 27 energy companies and a 2 percent stake in UES, according to Aton Capital. MDM bank values the coal firm's electricity assets at $2 billion.
Combined with Gazprom's $10.5 billion in UES shares, the joint venture would control at least 25 percent of Russia's generating capacity, and that is before any of the buyouts it has planned, Aton said in a note to investors Friday.
And Gazprom has its eyes on more than generation. In December, the monopoly created a new company to handle the dispatch and sale of electricity. The company began distributing power in January to all of Gazprom's affiliates, which jointly consume about 32 billion kilowatt hours per year, nearly enough to power Las Vegas.
SUEK also controls low-voltage power grids in the regions where it mines for coal, Hovhannisyan said.
On Nov. 28, Gazprom signed a far-reaching deal with Rosneft in which both companies pledged, among other things, to join forces in "the generation and sale of electricity and thermal energy," they said in a joint statement.
But even without the help of Rosneft, which does not hold much electricity stock, "Gazprom will have enough money for everything," said Andrei Gromadin, oil and gas analyst at MDM Bank.
As gas and electricity tariffs are gradually freed up over the next five years, the prices for both will rise exponentially, as will Gazprom's profits, Gromadin said.
Aton Capital highlighted the risks of a Gazprom hegemony Friday. Minority shareholders of generation companies, or gencos, may suffer, the bank said, as Gazprom is more likely to capitalize its oil and gas operations rather than the noncore power sector, which needs about $110 billion of capital for renovation, according to UES estimates reported last week. The bank also warned of an electricity monopoly -- and all the inefficiencies that come along with it -- spanning the vast Siberian operations of Gazprom and SUEK.
The main goal of electricity reform was to break up the national monopoly and introduce competition. Toward this end, UES advisers have consistently lobbied for a diverse investor base, even if it meant taking less money than the big strategic investors were offering. Chubais and Dmitry Akhanov, head of strategy at UES, have vocally favored portfolio investors and foreign firms with industry know-how.
Other elements within UES -- including UES chief financial officer Sergei Dubinin and Mosenergo general director Anatoly Kopsov -- have defended Gazprom's record.
The biggest upside to a monolithic power sector would be unity, said Gianguido Piani, a St. Petersburg-based energy expert. The ability to coordinate output is vital for meeting Russia's growing demand, Piani said, and a variety of small investors would bring chaos. He added that foreign investors, who have been wary of trusting the heads of the newly formed gencos, would be enticed by Gazprom's clout.
And when it comes to boosting supplies -- to building dozens of power stations and spending billions of dollars on repairs -- Gazprom may be the only one with such deep pockets.

Prokhorov Branches Out
But Prokhorov's pockets are not exactly shallow either. According to Forbes' rich list for 2006, Prokhorov was the country's eighth-richest man with a personal fortune of more than $6 billion. A survey published Monday by Finans magazine puts him in third place, tied with Potanin, at $14.2 billion.
Interros, the holding company Prokhorov founded with Potanin in 1990, has $15 billion of assets in industries ranging from banking, machine building and mass media, to its core business, metals. Norilsk Nickel, in which Interros holds the controlling stakes, is the largest producer of base metals in the world, and doubled its net earnings last year to $7.5 billion on the back of rising prices for nickel, a key ingredient for making steel.
The electricity holding Prokhorov plans to start after resigning from the top post at Norilsk will also be part of the Interros holding, and his loyalties to the umbrella company are expected to stay strong, Alfa Bank analyst Vladimir Zhukov said.
Unlike Gazprom, which is often criticized for inefficiency and bad management, Zhukov said Prokhorov was one of the savviest and most effective entrepreneurs in the country and is much praised for successfully turning Interros' gold assets into a $9 billion company, Polyus Gold, last year.
In its market note, Aton said a profit-driven group could be tempted to tinker with prices if it controlled a major part of the country's power supply.
In 2000 and 2001, this kind of price fixing was one of the main causes of the California energy crisis, which UES officials have often referred to as a worst-case scenario that they would do everything to avoid. That crisis arose when California liberalized its energy market in order to introduce competition and two private companies -- Enron and Reliant Energy -- ended up controlling the bulk of the state's power stations, grids and fuel. By restricting supply, the companies made prices soar until a state of emergency was called and almost 2 million customers faced rolling blackouts.
The California case is extremely unlikely to happen in Russia, analysts said, because the state will maintain control of the grid, and would step in to curb a sudden rise in prices.
Yet Prokhorov, unlike Gazprom, has no special ties to the state, and it is unclear how willing he will be to take advice from the Kremlin.

'Foreigners Keep Out'
At a recent press briefing, Chubais said his investment goal was "to support any foreign strategic company."
"The general principle is to attract not only financial investors but strategic investors who will own not 25 percent but 51 percent in at least two, three or four generation companies." He named Italy's Enel, Germany's E.On, and Finland's Fortum as the main potential partners.
But of the three, only Fortum has so far made any serious inroads. Its main asset is a blocking stake in TGK-1, which it may come to control after the company's July IPO.
Fortum vice president Kari Kautinen said in an e-mailed statement that the Finnish company was looking to buy a "substantial stake" in a number of gencos, but did not specify which ones.
"There are enough opportunities for many players in this field," she wrote.
Interros is also playing the field for TGK-1, with a stake of more than 7 percent in the company that should go to Prokhorov when he forms his holding.
TGK-1, which serves the Northwest Federal District, including St. Petersburg and the Leningrad region, enjoys two advantages that will make it worth fighting for. First, because it borders Finland, it exports more than 1 billion kilowatt hours per year to the lucrative European market. It is also the only genco allowed to produce power through hydro-generation, by far the most efficient method, which accounts for about half of its 6,200-megawatt installed capacity. The government-held Hydro-OGK is, and will remain, the only other purveyor of hydroelectricity.
When asked why TGK-1 enjoys these special privileges, Andrei Zubarev, its head of capital management, said: "It is because [St. Petersburg] is the home region of the president."
Italy's Enel runs the Northwest Thermal Power Plant, but owns none of it. It also holds 49 percent of Rusenergosbyt, a distribution firm recently undercut by Gazprom's distribution venture.
An Enel spokesman who requested anonymity said Enel was prepared to invest up to 4 billion euros ($5.2 billion) in the country's electricity sector. "We have capital, technology and engineers and I think this is the perfect mix for upgrading the electricity sector," he said.
Piani, however, was quick to explain away the interest of both foreign players mainly as a way of ensuring steady gas supplies from Russia. The state, he added, would resist their involvement.
"Electrical systems are considered a national strategic asset. It means: Foreigners keep out," he said.
As for portfolio investors, analysts agreed the power sector could not offer the quick turnarounds they like to see.
"Right now, the companies [in the electricity sector] demonstrate only limited profitability ... and the investors who are looking at them are looking three to five years ahead when the reform takes full effect," Andrei Burlinov, director of investment banking at Troika Dialog, told a recent news briefing.
Strategic, not portfolio, investors are the ones with the patience for such a long-term outlook, said Zoltan Szalai, another director of investment banking at Troika, which handled the IPO of OGK-5 and the restructuring of four other gencos last year.
Global ratings agency Fitch last month slammed Russia's power sector as a "very high-risk market," mainly due to political uncertainty.

Chubais' Legacy
By the end of next year, there will be no more UES, and Chubais will no longer be in charge of the country's electricity network. The landmark sign outside the UES headquarters in southwestern Moscow will have to be taken down, and its employees will have to look for work elsewhere.
"Oh, don't worry about me," UES chief spokeswoman Margarita Nagoga said. "All this power-sector trivia will come in handy somewhere."
For Chubais, however, the situation is not so clear. His decade-long crusade to save the electricity sector from ruin is, for better or worse, coming to an end. And of his future plans, he has said only that he will not go into politics.
His reasons for this are clear enough. His record as privatizations tsar under President Boris Yeltsin earned him the scorn of millions of Russians after he oversaw the 1995 loans-for-shares scheme, a proposal of Potanin's. The program sold off valuable state property to well-connected oligarchs at knockdown prices, helping them become billionaires. The scheme is still blamed by many for Russia's sharp economic divide.
"In a way, [UES reform] was his chance to make up for it," said Antanta's Terekhov. "If it doesn't work out, I don't know. You'd have to feel bad for the guy."